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Investment - Profit and Costs of Production
We have focused on supply and demand curves and how they influence equilibrium quantity and price. We have also looked at estimating demand variations by using the elasticity notion. Now, we move our attention to a company’s manufacturing costs and how these costs influence the company’s profitability. This is crucial because investors and analysts need to analyze a company’s capacity to produce money.
Accounting Profit vs. Economic Profit
Although accountants and economists agree that profit is the difference between the revenues gained from selling products and services and the cost of creating them, they disagree over how to calculate profit, partly because they do not necessarily examine the same sorts of costs.
Consider the proprietor of a restaurant in France. For a given period, the restaurant has revenues of EUR5,000,000. The costs of operating the restaurant, which include renting the premises, paying the workers, and procuring the raw food, is EUR3,000,000. The accounting profit analyzes only the explicit costs and is, in this case, EUR2,000,000 (EUR5,000,000 – EUR3,000,000).
But economists adopt a broader perspective of expenses and also deduct implicit costs from revenues and explicit costs to arrive at economic profit. The owner of the restaurant risks her capital by operating the restaurant; if the restaurant fails, she loses all her money. She may have used her skills differently and risked her capital differently.
Assume that the restaurant’s owner might obtain employment and make EUR1,600,000 by earning a salary and from investing her wealth elsewhere. The sum she may have gotten from these actions represents what economists call an opportunity cost.
An opportunity cost is the value forgone by choosing a certain course of action relative to the best option that is not taken.
Because the owner forgoes EUR1,600,000 by operating the restaurant, the restaurant’s accounting profit should be at least equivalent to this. Otherwise, operating the business is an inefficient deployment of its owner’s resources.
The economic benefit from operating the restaurant is EUR400,000, which is the accounting profit of EUR2,000,000 minus the opportunity cost of EUR1,600,000.
To determine accounting profit, only explicit costs are considered. To calculate economic profit, both explicit costs and the implicit opportunity costs are included.
Fixed Costs vs. Variable Costs
Fixed Costs
Companies combine people, capital equipment, raw materials, and managerial abilities to produce products and services. Costs that do not fluctuate with the level of the company’s output are called fixed costs or overhead, as seen in the graphic below.
We have focused on supply and demand curves and how they influence equilibrium quantity and price. We have also looked at estimating demand variations by using the elasticity notion. Now, we move our attention to a company’s manufacturing costs and how these costs influence the company’s profitability. This is crucial because investors and analysts need to analyze a company’s capacity to produce money.
Accounting Profit vs. Economic Profit
Although accountants and economists agree that profit is the difference between the revenues gained from selling products and services and the cost of creating them, they disagree over how to calculate profit, partly because they do not necessarily examine the same sorts of costs.
Consider the proprietor of a restaurant in France. For a given period, the restaurant has revenues of EUR5,000,000. The costs of operating the restaurant, which include renting the premises, paying the workers, and procuring the raw food, is EUR3,000,000. The accounting profit analyzes only the explicit costs and is, in this case, EUR2,000,000 (EUR5,000,000 – EUR3,000,000).
But economists adopt a broader perspective of expenses and also deduct implicit costs from revenues and explicit costs to arrive at economic profit. The owner of the restaurant risks her capital by operating the restaurant; if the restaurant fails, she loses all her money. She may have used her skills differently and risked her capital differently.
Assume that the restaurant’s owner might obtain employment and make EUR1,600,000 by earning a salary and from investing her wealth elsewhere. The sum she may have gotten from these actions represents what economists call an opportunity cost.
An opportunity cost is the value forgone by choosing a certain course of action relative to the best option that is not taken.
Because the owner forgoes EUR1,600,000 by operating the restaurant, the restaurant’s accounting profit should be at least equivalent to this. Otherwise, operating the business is an inefficient deployment of its owner’s resources.
The economic benefit from operating the restaurant is EUR400,000, which is the accounting profit of EUR2,000,000 minus the opportunity cost of EUR1,600,000.
To determine accounting profit, only explicit costs are considered. To calculate economic profit, both explicit costs and the implicit opportunity costs are included.
Fixed Costs vs. Variable Costs
Fixed Costs
Companies combine people, capital equipment, raw materials, and managerial abilities to produce products and services. Costs that do not fluctuate with the level of the company’s output are called fixed costs or overhead, as seen in the graphic below.
Fixed costs include costs linked with buildings and machinery, insurance, salaries of full-time personnel, and interest on loans.
Variable Costs
In contrast, costs that fluctuate with the level of output of the company are called variable costs, as seen in the exhibit below. Raw materials tend to be a variable cost because the more units the company produces, the more raw materials it needs.
Variable Costs
In contrast, costs that fluctuate with the level of output of the company are called variable costs, as seen in the exhibit below. Raw materials tend to be a variable cost because the more units the company produces, the more raw materials it needs.
Total Costs
The sum of fixed costs and variable costs equals total costs, indicated by the green line in the graphic.
The sum of fixed costs and variable costs equals total costs, indicated by the green line in the graphic.
Revenue Costs
The blue line in example below indicates the company’s revenues. If the revenues are higher than the total costs — the right side of the graph — the company is earning a profit. By contrast, if the revenues are lower than total costs – the left side of the graph — the company is experiencing a loss.
The blue line in example below indicates the company’s revenues. If the revenues are higher than the total costs — the right side of the graph — the company is earning a profit. By contrast, if the revenues are lower than total costs – the left side of the graph — the company is experiencing a loss.
In the long run, all elements of production can be changed and some costs that are viewed as fixed become variable because, for instance, a corporation can transfer its premises or purchase new equipment. Some costs, such as advertising, may be set but are also discretionary, meaning that the corporation can alter spending on them.
When production first starts, fixed expenditures associated to production will be incurred. As production increases, the average fixed costs or fixed costs per unit of output will fall because the fixed costs are spread over more units. For example, the same building is used to create more units of output. Average variable costs or variable costs per unit of production may also fall a little but are normally pretty steady. Average total costs or total costs per unit of output, which are the sum of both average fixed costs and average variable costs, should drop as output expands.
The drop in overall costs per unit will continue until one or more factors of production achieves full capacity or breaks down and additional resources must be added.
For example, machinery that is being utilized continuously, giving no time for maintenance, is prone to break down. Breakdowns result in lower output, expensive repairs, and higher overtime as workers move production to operating machines.
When this happens, additional fixed expenditures may be required, such as the purchase of a new machine. So, we watch total expenses per unit drop until the point of full capacity, and then we see them grow as new fixed costs are incurred.
Economies of scale are cost reductions stemming from a considerable increase in output without a matching growth in fixed expenses. These cost savings lead to a reduction in overall costs per unit as a result of increased production.
Economies of scale can be realized if, for example, staff, buildings, and machinery are unchanged but output grows, which results in reduced fixed costs per unit and lower total costs per unit.
Although adding inputs of one variable factor, such as manpower, to fixed inputs of production, such as machinery, increases total output, the gain in output will grow at a diminishing rate as labour increases, even if the fixed inputs of production remain same.
This economic theory is known as the law of diminishing returns and is shown in the following illustration.
The point at which the revenue and total costs lines connect is termed the breakeven point. It indicates the number of units produced and sold at which the company’s profit is zero, which is when revenues exactly cover all costs.
Effect of Fixed Costs on Profitability
The relative level of fixed and variable costs has a substantial effect on profitability.
Imagine the investment needed to create a steel mill, which is a facility or business that manufactures steel. If production levels are very low, the fixed expenses are large proportion to the revenues, and the steel mill will generate a poor profit or perhaps suffer a loss.
As production increases, variable costs will increase with more inputs going into the steelmaking process, such as acquiring raw materials and consuming greater electricity.
But as indicated before, the overall costs per unit of steel produced will reduce since average fixed costs will fall. The steel factory will be increasingly lucrative as output rises and its fixed expenses are dispersed over more units.
Companies and sectors with high fixed costs hence have higher opportunity for increased profitability by boosting output. Examples of high-fixed-cost projects are the construction of a significant gold mine and the construction of a shipbuilding plant.
Companies may boost capacity by incurring more fixed costs. For example, an airline can buy an additional aircraft and landing rights, or a retailer may open a new store. In many circumstances, economies of scale occur as fixed expenses are dispersed over more passengers or retail customers.
As total expenses per unit of a product reduce, profitability should improve, providing that the proper price has been chosen. The cost to the corporation of producing an incremental or additional unit is known as the marginal cost. The amount of money a corporation receives for that additional unit is known as its marginal revenue.
The general rule is that the marginal cost can be increased up to the point where it equals the marginal revenue. Producing to the point at which marginal revenue equals marginal cost will, in theory, maximise profit.
When production first starts, fixed expenditures associated to production will be incurred. As production increases, the average fixed costs or fixed costs per unit of output will fall because the fixed costs are spread over more units. For example, the same building is used to create more units of output. Average variable costs or variable costs per unit of production may also fall a little but are normally pretty steady. Average total costs or total costs per unit of output, which are the sum of both average fixed costs and average variable costs, should drop as output expands.
The drop in overall costs per unit will continue until one or more factors of production achieves full capacity or breaks down and additional resources must be added.
For example, machinery that is being utilized continuously, giving no time for maintenance, is prone to break down. Breakdowns result in lower output, expensive repairs, and higher overtime as workers move production to operating machines.
When this happens, additional fixed expenditures may be required, such as the purchase of a new machine. So, we watch total expenses per unit drop until the point of full capacity, and then we see them grow as new fixed costs are incurred.
Economies of scale are cost reductions stemming from a considerable increase in output without a matching growth in fixed expenses. These cost savings lead to a reduction in overall costs per unit as a result of increased production.
Economies of scale can be realized if, for example, staff, buildings, and machinery are unchanged but output grows, which results in reduced fixed costs per unit and lower total costs per unit.
Although adding inputs of one variable factor, such as manpower, to fixed inputs of production, such as machinery, increases total output, the gain in output will grow at a diminishing rate as labour increases, even if the fixed inputs of production remain same.
This economic theory is known as the law of diminishing returns and is shown in the following illustration.
The point at which the revenue and total costs lines connect is termed the breakeven point. It indicates the number of units produced and sold at which the company’s profit is zero, which is when revenues exactly cover all costs.
Effect of Fixed Costs on Profitability
The relative level of fixed and variable costs has a substantial effect on profitability.
Imagine the investment needed to create a steel mill, which is a facility or business that manufactures steel. If production levels are very low, the fixed expenses are large proportion to the revenues, and the steel mill will generate a poor profit or perhaps suffer a loss.
As production increases, variable costs will increase with more inputs going into the steelmaking process, such as acquiring raw materials and consuming greater electricity.
But as indicated before, the overall costs per unit of steel produced will reduce since average fixed costs will fall. The steel factory will be increasingly lucrative as output rises and its fixed expenses are dispersed over more units.
Companies and sectors with high fixed costs hence have higher opportunity for increased profitability by boosting output. Examples of high-fixed-cost projects are the construction of a significant gold mine and the construction of a shipbuilding plant.
Companies may boost capacity by incurring more fixed costs. For example, an airline can buy an additional aircraft and landing rights, or a retailer may open a new store. In many circumstances, economies of scale occur as fixed expenses are dispersed over more passengers or retail customers.
As total expenses per unit of a product reduce, profitability should improve, providing that the proper price has been chosen. The cost to the corporation of producing an incremental or additional unit is known as the marginal cost. The amount of money a corporation receives for that additional unit is known as its marginal revenue.
The general rule is that the marginal cost can be increased up to the point where it equals the marginal revenue. Producing to the point at which marginal revenue equals marginal cost will, in theory, maximise profit.
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